Investor alert! Innovative growth companies set to shine as inflation fades

The ASX 200 is up nearly 11 per cent and the Nasdaq is up 34 per cent. Picture: Bloomberg

This week another nail was hammered into the coffin of US inflation, and investors should be encouraged.

Since November last year, this column has explained why investors should be buying equities, especially those of innovative growth companies.

In a welcome sign inflation is easing its grip on the world’s biggest economy, on Wednesday the US Labor Department said its consumer price index had climbed 3 per cent in June from a year earlier.

The encouraging number was down from 4 per cent in May and materially lower than the peak inflation rate of 9.1 per cent in June 2022.

Inflation is now cooling to its slowest pace in more than two years, which provides consumers relief from a painful period of rising prices, while giving investors hope that the Federal Reserve will soon end the current cycle of interest rate hikes, after a widely anticipated increase this month.

Indeed, this week’s picture of easing inflation resonated with investors immediately, with US stocks rising and bond yields falling.

The pace of declining inflation in June, however, might not be repeated until early 2024 thanks to less favourable comparisons (“comps”) to come.

Meanwhile, the trend in inflation may also be dependent on whether pandemic-related anomalies, like the surge and subsequent cooling of car prices, is repeated. In fact, elevated car prices have driven up auto insurance rates, which could remain high into early next year.

Nevertheless, disinflation is now well and truly entrenched, and when combined with positive economic growth, conditions are ideal for innovative growth stocks, which are typically found in sectors such as technology, biotech, and green energy. These firms are characterised by their investment in research and development and are often in the initial or fast-growing phase of their business life cycle.

Gavekal Research, a global economic research firm, has long provided compelling evidence of the benefits to investors in innovative growth stocks of the combination of disinflation and economic growth.

Historically, a disinflationary environment portends declining interest rates, benefiting growth companies by reducing their cost of capital and increasing the net present value of their expected future earnings, and subsequently, their stock prices.

Meanwhile, positive economic growth generally leads to an increase in consumer and business spending. For innovative growth companies, this increased spending can mean greater revenues, higher profits, and, ultimately, a boost to their stock price.

But why has the combination of these two factors worked so well historically? Essentially, positive economic growth ensures there is enough market demand to support these companies’ innovative products and services. At the same time, disinflation keeps borrowing costs low, enabling these firms to invest in growth opportunities.  

Gavekal’s research also indicates that this combination of factors may be particularly beneficial for innovative companies because it creates a “sweet spot” where macroeconomic conditions foster growth without leading to excessive inflation that could trigger tighter monetary policies. In essence, the “Goldilocks” scenario of disinflation coupled with positive economic growth can create an environment that is ”just right” for innovative growth stocks.

Of course, it all sounds strange talking about declining rates and “ideal” conditions when so many economists and strategists remain convinced we are at the precipice of a recession and a decline in stock prices. And yet, as we predicted in this column back in November, 2023 has already turned out pretty well for investors in the major indices.

The S&P 500 is up nearly 17 per cent, the ASX 200 is up nearly 11 per cent and the Nasdaq is up an impressive 34 per cent.

Sure, the Fed is poised to raise rates to a 22-year high at its July 25-26 meeting, largely due to economic activity and particularly labour not slowing sufficiently.

But while many investors quibble about the economy being too strong or falling into recession, and that inflation might not decline further, they have missed the gains delivered by six months of combined disinflation and economic growth, which Gavekal noted in the 1970s was positive for innovative growth stocks.

The Fed is targeting an inflation rate of 2 per cent over time and June inflation will provide comfort to policymakers as core prices, which exclude volatile food and energy categories, posted the smallest monthly gain in two years.

Expect disinflation to continue.

According to the Fed‘s regular survey of the economy, prices have increased only modestly since late May as inflation shows signs of easing. Businesses are reluctant to raise prices due to heightened consumer sensitivity to inflation, while solid demand has allowed some to maintain profit margins.

The combination is plainly encouraging for investors.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management